How to Invest in Bonds for Beginners UK

The UK has a deep-rooted history with bond markets. The relationship dates back to 1694, when it incorporated its central bank, the Bank of England, specifically to raise funds for England’s war effort against France.

But bonds didn’t start here. They are among the oldest financial instruments used by governments, corporations, and individuals. Throughout history, bonds have contributed to economic growth and financial crises.

Bonds began in Venice in the 1100s, funding wars and public works. Later, they evolved into negotiable instruments traded assets by City-states and monarchies. The Rothschilds traded European government bonds in the 18th and 19th centuries. Bonds funded colonial expansion and the transatlantic slave trade. During the Industrial Revolution, mega projects like canals and railroads were all backed by bonds, which contributed to economic development and urbanisation. The global bond market is worth over £100 trillion today, according to the Securities Industry and Financial Markets Association’s records.

If you intend to learn how to invest in bonds UK and learn how they work today, here is a detailed look at everything there is about them.

What are Bonds?

A bond is a loan you give to a public or private institution in exchange for regular interest payments and a refund on a set future date.

Bonds are like regular loans but with a critical difference: once issued, you can trade them with other investors in the financial market. Essentially, a bond has a market price.

Typically, the borrower who issues the bond is called the “Issuer,” while the lender is known as the “Holder.” The issuers are corporations or governments, while the holders are individuals or institutions, e.g., banks. So, in government bonds, the borrower is the government, while in corporate bonds, the borrower is a company.

When talking about bonds in the UK, we must mention Gilts. A gilt is a government-backed bond denominated in pounds, issued by His Majesty Treasury, and listed on the London Stock Exchange. So, when you buy a gilt, you lend to the UK government in return for periodic interest. They repay you the amount you lent them back at the end of the agreed term.

The term “gilt” means something resembling gold; indeed, bonds, like gold, are safe investments. Their safety as an investment makes them so popular with investors. Besides the low risk, you should consider investing in them for two other reasons:

• They assure you of a predictable cash stream over time.
• You can quickly sell them in the secondary to sell bonds for a profit.

Types of Bonds

Besides Gilts and Corporate bonds, we also have municipal bonds issued by local authorities. But they are less common in the UK than in some countries.

Another variant is investment-grade bonds. These have a higher credit rating and a lower risk of default.

Finally, as the name suggests, we have high-yield or junk bonds offering higher yields. Nonetheless, they are more risky because of their low credit ratings.

Bonds can be low-risk or high-risk, conventional with a fixed interest rate or index-linked. Inflation rates significantly affect their pricing. Those issued by companies raising capital carry a higher risk than gilts but offer higher yields.

Bonds are sold to investors through brokers or investment houses when issued. However, you can buy gilts directly from the UK Government Debt Management Office (DMO). In return for buying the bond, investors receive coupon payments. The interest comes in once or twice a year, depending on the bond type. Upon maturity, the bondholder gets back the face value, or par value, unless there’s a default.

Bonds can have varying maturity dates, categorised as short-term, medium-term, or long-term. But you don’t have to hold a bond till its maturity. You can trade them on trading platforms, with their market price sometimes different from their face value. So, you can buy from another investor or sell your holdings before maturity. Let’s look at how they work.

How do Bonds Work?

When borrowers issue a bond, they determine the face value, also known as the par value or redemption value, which is printed on the bond. This amount represents what the issuer commits to repay at maturity. The bond also specifies the coupon rate or yield and the maturity date. The coupon rate is the interest rate paid annually or semi-annually based on the bond’s face value.

As the investor lending the money, this face value is the loan principal, while the interest rate is your investment’s rate of return.

Here is how a bond lists in the market: ‘3% Treasury stock 2030’.

In this example, ‘Treasury stock’ declares the issuer to be the UK government. On the other hand, 3% is the bond yield or coupon rate, usually paid in half-year instalments.

Suppose the bond’s face value is £100. The bond earns £3 annually or £1.50 half-annually. If this bond trades in the secondary market, it can trade for more or less than that value. If you buy it for less than £100, you may hold it to receive interest payments and perhaps hang on until 2030, the redemption date. The bondholder gets their premium back on the redemption date.

The coupon rate reflects the bond’s comparative security. Generally, riskier bonds have a higher coupon, while safer ones have a low yield rate.

You can opt out of a bond by trading it on the secondary market, just as we trade stocks and shares. However, the bond can be traded at a premium or discount based on its face value. So, the bond’s face value differs from its price in the trading market. The critical difference is that the face value remains constant until the bond reaches maturity, while the price is subject to market factors. This price fluctuates based on the issuer’s creditworthiness, economic conditions and interest rates.

Also, if this price moves in the opposite direction to the bond’s yield. When the price rises, the bond’s yield will fall—and when the price falls, the yield rises.

The bond market depends on the central bank’s official interest rate, which is the base for the rates offered by banks and building societies. When interest rates shoot, bond prices usually fall, and yields go up, and the reserve is true. Investors often seek a specific return, and the general interest rate influences their choices.

When interest rates rise, investors’ required rate of return also rises. They may prefer newer bonds with higher yields and pay less for existing bonds. So, they’ll rush to sell the existing bonds and push down bond prices. If the interest rate falls, investors would be ready to pay more for these fixed-rate bonds, pushing the demand up, and hence, the bond prices may rise.

How to Trade Bonds UK: Step-by-step Guide

If you’ve decided to trade bonds, here is how to do it in a few steps:

Bonds Trading Risks in the UK

Bonds are safer than shares, but no investment is guaranteed. While bond issuers promise to pay coupons and repay the principal at maturity, losses can still occur. Key risks include:

• Default risk: The issuer may not repay the loan or interest. Bond investors rank higher than shareholders for repayment, but it’s not guaranteed. Assess the issuer’s creditworthiness, as credit ratings can change quickly and are not foolproof.
• Interest rate risk: As we already said, rising interest rates lower bond prices, while falling rates increase them. This is especially true for longer-dated bonds.
• Inflation risk: By now, you know that inflation reduces the value of fixed-interest coupons. This makes bonds less attractive and lowers their demand and prices.
• Currency risk: As always, buying stuff in another currency exposes you to exchange rate changes. The same applies to bonds, which affect returns when converted back to pounds.

Where Can You Buy and Sell Bonds?

When a company issues bonds, it often hires an investment bank to ‘underwrite’ the process. This means the bank buys the bonds from the company at a fixed price and sells them to big institutions or funds. Buying corporate bonds directly from institutional broker-dealers usually requires a large minimum investment, which can be costly for retail investors. However, you can still invest in bonds by owning the underlying asset. When trading bonds, you take a ‘buy’ position if you expect the bond’s value to rise or a ‘sell’ position if you expect it to fall. You can invest through share dealing or trade using spread bets and CFDs. Whether you pick a bond or a bond ETF, effectively managing your risk is essential.

In the UK, you gilts in three ways:

1. Directly from the HM Debt Management Office or an authorised agent.
2. Through shares in a bond ETF or fund.
3. By trading government bond futures using spread bets or CFDs.

Conclusion

Corporate and government-backed bonds are among the world’s most traded financial assets. They offer steady returns, making them valuable in uncertain times. Adding bonds to your investment portfolio can enhance economic stability. Online trading platforms have made accessing these investments easier. Choose one of our listed brokers to start trading bonds and improve your financial well-being today.